Three themes ETF investors should watch

Three themes emerge when examining the latest monthly performance of exchange-traded funds in Canada that investors should pay attention to.

First, year-to-date returns have been good to investors who looked abroad. For example (and we’ll use iShares Canada ETFs to illustrate as it is still the dominant player), the MSCI World Index Fund is up 19.8%, its EAFE equivalent is up 17.25%, and, perhaps more relevant to Canadians, U.S. exposure has also moved meaningfully higher. The Russell 2000 Small Cap Index (CAD Hedged) is up 27.7%, the Nasdaq 22% and the S&P 500 19.7% (the latter two also hedged in terms of the Canadian dollar).

Secondly, the worst year-to-date performers primarily consist of gold and base-metals ETFs. This, extended to our domestic equities market, also goes a long way to explaining Canada’s continuing underperformance with returns materially lower than those of our developed-market peers.

Finally, while the benefits of indexing are perhaps most significant in the world of equities, investors have, since the 2008/2009 financial crisis, been plowing increasing amounts into fixed-income ETFs. In 2008, 65.7% of the $18.9-billion in aggregate ETF assets were in Canadian equities. That number has plummeted to 41.4%, although overall assets grew to $60-billion as of the end of September 2013. Bond-related ETFs, meanwhile have grown to 37% from 12.1% during the same time period.

Bonds have a place in most portfolios and act as a stabilizing force when turmoil enters the picture, but the 30-year bull market in bonds was correctly pronounced over by fixed-income market authority Bill Gross of Pimco earlier this year. Despite a bounce in September, year-to-date numbers show many bond ETFs in negative returns territory.

Points two and three should be of great concern to Canadian investors. If the move into bonds confirms a broad-based and still-prevailing risk aversion, it means many investors haven’t participated in the upside markets have posted since the financial meltdown. Many may have done even worse, by selling at or close to the bottom, and then hiding in fixed income.

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Further, if Canadian equities do not begin providing better returns, and bond returns going forward have no hope of providing the positive contributions made in recent years, the total return picture of a home-biased portfolio will become significantly challenged.

More international diversification would seem to be the answer. But while opportunities to invest abroad abound, one would have to accept that the kinds of returns witnessed so far this year aren’t exactly indicative of the kind of contribution these markets can be relied on to provide in future.

Since a challenging returns picture is likely to emerge, investors will increasingly be forced to assess how well their portfolios are faring and this exercise is bound to lead them to realize that the cost side of the equation matters more than ever — and has been out of synch for quite some time.

For the financial services industry, this represents a key risk given the availability and variety of ETFs, which are substantially cheaper than mutual funds. Combine this with a demographics outlook that demands higher returns to support the tsunami of boomers retiring in coming years, and the cocktail is potent.

In any other industry, better and cheaper products eventually dominate. In Canadian finance, the more expensive and inferior product still dominates. How long until that changes?

If this scenario unfolds, the Canadian market could suffer a blow given the significant weight of financials here, and the positive performance contribution the sector has made to offset the devastation felt on the cyclical side of things. Even the possibility of resurgent energy and materials stocks might not be able to fully shield the market from that hit.

Either way, greater diversification and a sharpened focus on cost/return as well as risk/return are in the cards.

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By clicking "Create Account", I hearby grant permission to Postmedia to use my account information to create my account.

I also accept and agree to be bound by Postmedia's Terms and Conditions with respect to my use of the Site and I have read and understand Postmedia's Privacy Statement. I consent to the collection, use, maintenance, and disclosure of my information in accordance with the Postmedia's Privacy Policy.